Fixed income

Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. When you invest in fixed income, you are in effect loaning your money to a governement, corporation or other entity to finance and expand their operations. In exchange, the issuer promises to pay you back the capital at maturity, plus interest, typically in the form of fixed periodic payments.

A common type of fixed income investment is a bond. Other common types are savings bonds, and guaranteed investment certificates (GICs) issued by a variety of financial institutions. Some investors think of preferred shares as a type of fixed income.

Fixed income is one of the main asset classes, along with equities and cash (including money market instruments).

This article serves as an entry point for fixed income topics on finiki and covers some general information applicable to most types of fixed income. The article first lists the main types of fixed income and briefly discusses the role of fixed income for short-term and long-term investing. It then deals with prices, yields, and accrued interest.

Types

Bonds

A bond is a negotiable certificate that acknowledges the indebtedness of the bond issuer to the holder. It is negotiable because the ownership of the certificate can be transferred in the secondary market. It is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (semi annual, annual, sometimes monthly).

In Canada, bonds are issued by the Government of Canada, provincial governments, municipalities, agencies and corporations.

The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond.

• Conventional bonds (also called "nominal bonds"; mostly covers investment-grade Canadian bonds)
• Foreign bonds
• High yield bonds
• Real Return Bonds (RRBs)

Bonds can be purchased one by one through a discount broker, but many investors access them though bond mutual funds or bond exchange-traded funds.

Savings bonds

A savings bond is a loan to a government that is secured by the general credit and taxation powers of the government. They are not negotiable and are usually offered for sale at certain times of the year. Savings bonds are almost extinct in Canada.

Term deposits and GICs

Investopedia defines a term deposit as: "A deposit held at a financial institution that has a fixed term. These are generally short-term with maturities ranging anywhere from a month to a few years. When a term deposit is purchased, the lender (the customer) understands that the money can only be withdrawn after the term has ended or by giving a predetermined number of days notice."

In Canada, the name Guaranteed Investment Certificate (GIC) is commonly used for term deposits from 1 year to 5+ years, and those are fixed income investments.

Term deposits with shorter locked-in periods (30, 60, 90, 120 and 180 days) are also available from banks and brokers, but those fit in the cash and cash equivalents asset class instead.

Preferred shares

Some investors also classify preferred shares as fixed income for asset allocation purposes, while others think of them as a type of equities. There are arguments that can be made by either side and there is no clear consensus. It is left to the individual investor to determine the classification that makes the most sense in their situation.

Role of fixed income

Short term investing

To fund a project within 5 years or less, investing entirely in fixed income and/or cash could be appropriate. For example, an investor wants to buy a house in 3 years and invests the downpayment in a 3 year GIC with CDIC coverage.

Liability matching

Liability matching strategies allow an investor planning for retirement or other goals to meet specific financial targets with near certainty. The house downpayment scenario above is a very simple example of liability matching. Another example would be to position a Registered Education Savings Plan (RESP) to provide equal (or unequal, if desired) cash flow over a 4 year university degree by investing in GICs of suitable maturies.

A more complex example would be to have enough invested in fixed income (or annuities) to fund a retirement income floor, i.e. essential expenses, perhaps over a multi-decade period.

Long term portfolios

Many long term portfolios mix fixed income investments with other asset classes such as equities, a form of diversification. A classic example is the 'balanced' portfolio which has 60% stocks and 40% fixed income (bonds and/or GICs). In this context, the fixed income portion is mainly there to reduce portfolio volatility (the variations in investment returns over time), and perhaps provide some current income for spending (for retirees). See Getting started and Portfolio design and construction.

Pricing and yields

Yield is defined as:

Current Yield = Annual dollar coupon interest / Price

If you purchase a GIC from a bank and hold it to maturity (the typical scenario), the yield will be your entire return on the investment. With bonds purchased on the secondary market, the total return may also include capital gains or losses.

Canadian newspapers and websites carry sections listing current pricing and yields of various benchmark bonds. These prices are typically wholesale prices (and therefore yields) and therefore are not available to the retail investor who is buying bonds.

Accrued interest

For a type of obligation such as a bond, interest is calculated and paid at set intervals. However ownership of bonds can be transferred between different investors at any time, not just on an interest payment date. After such a transfer, the new owner will usually receive the next interest payment, but the previous owner must be compensated for the period of time for which he or she owned the bond. In other words, the previous owner must be paid the interest that accrued before the sale.

Specifically, the purchaser of the bond is obligated to pay the seller the accrued interest due on the bond at the settlement date. Canadian conventions on calculating accrued interest are generally as follows:

• For money market instruments with less than one year to maturity, an "actual/365" day count convention is used. This is similar to American practice.
• For most bonds or GICs, an "actual/365" day count convention is also used. This differs from American practice, which is usually "actual/actual" for terms longer than one year.

Risks

Generally speaking, when looking at a fixed income, you need to consider different types of risk.

See also

• Asset allocation
• Portfolio design and construction

External links

• Wikipedia, Yield curve
• Wikipedia, Fixed income analysis
• Wikipedia, Day count convention for the formulas and math behind accrued interest calculations.